9/27/2016
Delta Beverage Group, Inc.
Group 5 Haci Mustafa Sahin – 2543058 Tarik Egirgen – 2543060 Morsal Sarwarzadeh - 2539387
In this report we will give insight in the current financial situation of Delta Beverage Group, Inc. Furthermore, we will advise you regarding the problems and short comings of the company. Firstly, we will be pointing out the key problems by analyzing the business and financial risk of Delta Beverage in the soft drinks industry. Next we will discuss a hedging program using aluminum futures contracts, this will be done by a scenario analysis. In the end we will give Mr. Bierbaum an advice on whether he should hedge aluminum using futures contract or not. Business risk Delta Beverage is a large bottling company and a part of the PepsiCo franchise. Looking at the sales we see that Delta Beverage is a large company. The sales volume has increased the past few years, especially due to the taken number of acquisitions. Competition became a problem in 1989 when CCE succeeded in buying some of the competing brand franchises in the same areas. A new management team had been hired which succeeded in stopping the fall in prices and the dwindling market share and also increased the margins by attacking the cost structure. Despite the positive impact of the recapitalization plan in 1993, net income is still negative due to the high interest expenses, although it increased by almost 100 percent. It’s important to still focus on the cost structure, so that the company will be able to make profits. As told before Delta Beverage is a franchise of PepsiCo. One of the obligations of being a franchise is that Delta Beverage has to buy its concentrates and syrups from PepsiCo only. This means Delta Beverage is not able to influence the given price, so it should focus on the cost structure of the bottles and cans. Further, the price of aluminium, which is a core raw material, had risen 30 percent on the London Metal Exchange during the first half of 1994. As a result of this there is a high chance the price of aluminium cans rises. This will have a high impact on the cost of goods sold because these aluminium cans are a key cost component. This situation will again lead to continuing losses. To hedge against this risk, we will consider a hedging program using aluminium futures To give a good view on the several calculated ratios it’s important to know in which phase of the product life cycle soft drinks are situated. Delta Beverage operates in the soft drinks industry, which shows diminishing growth in the US industry. Remarkable is the relatively high consumption of soft drinks in the South areas of the US. Considering the diminishing growth of the whole US soft drinks industry and the high leverage of Delta Beverage (see exhibit 1), we conclude that the company is in the maturity phase of the product life cycle, which mostly indicates a high leverage level. Long term financing risk Exhibit 1 shows the long term financing risk Delta Beverage has to deal with. The debt to equity ratio increased extremely during the period of 1989-1992. The 1993 recapitalization plan has caused a sharp decrease, but the ratio is still excessive. The debt ratio also shows the high leverage of Delta Beverage. For a company which is in the maturity phase of the product life cycle it’s normal to have a higher debt, but the debt ratio is still extreme in this case. Although the 1993 recapitalization plan lowered the debt level, it still shows a high financing risk which make it less attractive for shareholders to invest in the company. In case of bankruptcy shareholders will lose all their money because the debtholders will be
paid first. Also this high long term financing risk leads to a situation where the company can’t get any additional borrowing funds and has to deal with less financial flexibility. So maintaining the 2.00 interest coverage ratio is key since attracting new additional long term debt is hard. Exhibit 1: Long term financing risk Debt Equity Debt to equity ratio Total assets Debt ratio
1989 188484 34851 541% 223335 84%
1990 181543 28526 636% 210069 86%
1991 186262 17737 1050% 203999 91%
1992 206752 3686 5609% 210438 98%
1993 166572 47134 353% 213706 78%
Short term financing risk Exhibit 2 shows the short term financing risk over the past few years. The working capital ratio and the quick ratio gives an indication whether delta beverage is able to meet its short term obligations. It’s important to have a working capital ratio and quick ratio of 1 (or higher). We see that the working capital ratio had decreased during the period 1989-1992. Due to the 1993 recapitalization plan the working capital ratio increased by 82.3 percent. A ratio of 2.77 indicates that the company is able to meet its short term obligations. The same applies to the quick ratio, which gives almost the same insight as the working capital ratio but it deducts inventories from the current assets. Based on exhibit 2 we conclude that the short term financing risk of delta beverage is low, which indicates a strong liquid position where Delta Beverage is able to meet its short term obligations. Exhibit 2: Short term financing risk
Current assets Current liabilities Net working capital Working capital ratio Inventories Quick ratio
1989 39254 22733 16521 1,73 8893 1,34
1990 33196 19233 13963 1,73 6726 1,38
1991 36204 21998 14206 1,65 9808 1,20
1992 41349 27291 14058 1,52 10607 1,13
1993 50192 18147 32045 2,77 10104 2,21
Scenario analysis The debt of the company is restructured with the 1993 Recapitalization Plan. With these new senior notes, the company has to meet new loan covenants. These covenants include to maintain a certain senior leverage ratio, a total leverage ratio and an interest coverage ratio. The biggest concern of the company should be the aluminium prices. Aluminium packaging is 49% of the costs for a can, while these cans also contribute for 60% of the sales. The can manufacturers are suffering from higher aluminium prices; however, it isn’t clear how this will affect the company. We expect that it can have a big impact due to the high weight of aluminium packaging in the cost of goods sold. By hedging this risk can be mitigated. Since an operational hedge is not an option, a financial hedge
should be considered by using futures for the aluminium prices since there are no futures available for fructose concentrate and other raw materials. We calculated the required rates for the covenants from 1993-1996 in different scenarios to predict the expected impact of the price. A summary of these situation and the impact on the required ratios can be found in Exhibit 3, a more detailed view is on Exhibit 4 and 5 at the end of the report. For the calculations a couple of assumptions have been made. We expected a 4% growth. First we calculated two scenarios where no hedging takes place and the prices increase by 22.5% and 15%. You can immediately observe that a price change of 22.5% will affect the ratios heavily, bringing it to a level below the required levels of the covenants. In the scenario with a price increase of 15% everything seems fine, however it is still a risky scenario. Next we created two scenarios with fully hedging, both seem to satisfy the covenants significantly. We hedged for the years 1995 and 1996 since in 1994 the prices were fixed due to the co op. However, by hedging fully we excluded possibly situations where the prices will drop below the expected levels with hedging. This way we might miss on some opportunities that come with a price drop. That is why we created one last scenario where we decided to hedge partially. By hedging for 46% and a price increase of 22.5% the interest coverage ratio will be breakeven, while satisfying the other covenants. However, this still might be a bit risky in case the price increases even higher than 22.5% due to the high volatile market. So our advice to Mr. Bierbaum is to hedge partially. Between 50-60% seems reasonable and will leave a significant amount open for possible price drops that might affect the firm advantageously.
Exhibit 3: covenant requirements Scenario: Ratio Required levels Interest Coverage > Total Leverage < Senior Leverage < 22.5% Price increase Interest Coverage Total Leverage Senior Leverage 15% Price increase Interest Coverage Total Leverage Senior Leverage Hedging 15M Interest Coverage Total Leverage Senior Leverage Hedging 27M Interest Coverage Total Leverage Senior Leverage Partial 46% Hedging Interest Coverage Total Leverage Senior Leverage
1993 2,00 6,40 5,15 2,12 5,70 4,24 2,12 5,70 4,24 2,12 5,70 4,24 2,12 5,70 4,24 2,12 5,70 4,24
1994 2,00 6,25 5,00 2,49 4,86 3,58 2,49 4,86 3,58 2,49 4,86 3,58 2,49 4,86 3,58 2,49 4,86 3,58
1995 2,00 6,25 5,00 1,62 7,45 5,40 2,00 6,06 4,39 2,43 4,99 3,61 2,31 5,24 3,80 2,00 6,06 4,39
1996 2,00 5,75 4,50 1,80 6,73 4,78 2,20 5,49 3,91 2,67 4,53 3,22 2,54 4,76 3,38 2,20 5,49 3,91
Recommendation Mr. Bierbaum has a difficult decision to make, so we provided him different scenarios. By taking a quick look we can see that a 15M hedge seems to offer the best result. However, if we look closely to the cash and future price differences we notice a 6-8% difference. Futures being higher. That is why we recommend Mr. Bierbaum to not hedge fully. In our calculations we have made it clear that by hedging for 46% and increase of prices by 22.5% the interest coverage ratio will be exactly 2.00 which satisfies the required level of the covenant. Due to volatile aluminium prices it would be better to hedge a larger part of the prices. Our advice is between 50-60% so a slightly higher price increase than 22.5% wouldn’t exceed the interest coverage covenant. Although we have mentioned the volatile prices mostly as a negative risk it might be a positive risk as well. The high volatility of the aluminium prices can cause the prices to drop under the futures level which might be more advantageous then a fully hedged scenario. So by hedging partially Mr.Bierbaum can mitigate the impact of the volatile aluminium prices on his business, but still have opportunity to take advantage of the same volatile prices.